Order Code RL34427
Financial Turmoil: Federal Reserve
Policy Responses
Updated April 7, 2008
Marc Labonte
Specialist in Macroeconomic Policy
Government and Finance Division

Financial Turmoil: Federal Reserve Policy Responses
Summary
The Federal Reserve (Fed) has been intimately involved in the current financial
turmoil since it began in August 2007. It has sharply increased reserves to the
banking system through open market operations and lowered the federal funds rate
and discount rate on several occasions. As the turmoil has progressed without signs
of subsiding, the Fed has introduced new policy tools to try to restore calm.
In December 2007, it began to auction off reserves to member banks through the
newly created Term Auction Facility (TAF). Equivalent in economic effect to the
discount window, the TAF allows the Fed to control how much direct lending was
undertaken and removes the stigma attached to the discount window that may have
made member banks reluctant to access it. In March 2008, it created the Term
Securities Lending Facility (TSLF) to expand its Treasury securities lending program.
Under the new program, it allowed the primary dealers (financial institutions who are
counterparties to the Fed in its open market operations) to temporarily swap their less
liquid assets for Treasury securities. Later, it created the Primary Dealer Credit
Facility (PDCF), which allowed it to temporarily lend to primary dealers directly.
Unlike the TAF or TSLF, the PDCF is a major departure from past policy, for it is
the first time that financial institutions that are not members of the Federal Reserve
System (i.e., depository institutions) have been allowed to borrow directly from the
Fed on a routine basis.
On March 16, 2008, JP Morgan Chase agreed to acquire Bear Stearns. As part
of the agreement, the Fed announced a $29 billion loan to a corporation it created to
buy $30 billion of assets from Bear Stearns. In the event that the proceeds from the
asset sales exceed $30 billion and the outstanding interest, the Fed will keep the
profits. In the event that the loan principal and interest exceed the funds raised by the
liquidation, the first $1 billion of losses would be borne by JP Morgan Chase, and
any subsequent losses would be borne by the Fed. The statutory authority for the
loan was based on a clause of the Federal Reserve Act to be used in “unusual or
exigent circumstances” that had not been invoked in more than 70 years.
Loans through all programs are fully collateralized. Any losses borne by the Fed
from the JP Morgan Chase loan or any of the new programs would reduce the profits
it remits to the Treasury. It is highly unlikely that losses would exceed its profits and
capital, and require revenues to be transferred from the Treasury.
The primary policy issues raised by the Fed’s response to financial turmoil are
the issues of systemic risk and moral hazard. Moral hazard refers to the phenomenon
where actors take on more risk because they are protected. The Fed’s involvement
in JP Morgan Chase’s acquisition of Bear Stearns stemmed from the fear of systemic
risk (that the financial system as a whole would cease to function) if Bear Stearns
was allowed to fail. In other words, Bear Stearns was arguably seen as “too big (or
too interconnected) to fail.” The Fed’s regulatory structure is intended to mitigate the
moral hazard that stems from access to government protections. Yet Bear Stearns
was not under the Fed’s regulatory structure because it was not a member bank.

Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Traditional Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Open Market Operations and the Federal Funds Rate . . . . . . . . . . . . . . . . . . 2
The Discount Window . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
New Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Term Auction Facility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Term Securities Lending Facility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
What is a Primary Dealer? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Primary Dealer Credit Facility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
The Fed’s Role in the JP Morgan Chase Acquisition of Bear Stearns . . . . . . . . . 7
Policy Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Cost to the Treasury . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Lender of Last Resort, Systemic Risk, and Moral Hazard . . . . . . . . . . . . . . 11
Liquidity Trap? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Stagflation? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Concluding Thoughts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
List of Tables
Table 1. Use of Funds Raised by Liquidation of Bear Stearns Assets . . . . . . . . . 9

Financial Turmoil: Federal Reserve
Policy Responses
Introduction
On August 9, 2007, liquidity abruptly dried up for many firms and securities
markets. Suddenly some firms were able to borrow and investors were able to sell
certain securities only at prohibitive rates and prices, if at all. The “liquidity crunch”
was most extreme for firms and securities with links to subprime mortgages, but it
also spread rapidly into seemingly unrelated areas.1 Some have observed that the
most unusual aspect of the current turmoil is its persistence over several months.
The Federal Reserve (Fed) was drawn into the liquidity crunch from the start.
On August 9, it injected extremely large reserves into the banking system (compared
to normal) to prevent the federal funds rate from exceeding its target. As financial
turmoil has persisted in the intervening months, the Fed has aggressively reduced the
federal funds rate and the discount rate in an attempt to calm the waters. When this
proved not to be enough, the Fed developed several new lending programs, some of
which can be seen as adaptations of traditional tools and others which can be seen as
more fundamental departures from the status quo. Most controversially, the Fed was
involved in the “bailout” of the investment bank Bear Stearns, which was not a
depository institution, meaning it was not a member of the Federal Reserve system
and, therefore, not part of the regulatory regime that accompanies membership.2
Lending to non-members requires emergency statutory authority that has not been
used in more than 70 years.3
One of the original purposes of the Federal Reserve Act, enacted in 1913, was
to prevent recurrence of financial panics. To that end, the Fed has been given broad
authority over monetary policy and the payments system, including the issuance of
federal reserve notes as the national currency. As with any statutory delegations of
authority, the Fed’s actions are subject to Congressional oversight. Although the
Fed has broad authority to independently execute monetary policy on a day-to-day
basis, questions have arisen as to whether the unusual events of recent months raise
1 For more information see CRS Report RL34182, Financial Crisis? The Liquidity Crunch
of August 2007
, by Darryl Getter et al.
2 Many of the loans and new programs described below are operated through the Federal
Reserve Bank of New York, under the authorization of the Board of Governors. This report
uses the term Federal Reserve, and does not distinguish between actions taken by the Board
and actions taken by the Federal Reserve Bank of New York. The Federal Reserve System
is composed of the Board of Governors and twelve regional banks.
3 Federal Reserve Bank of New York, “The Discount Window,” Fedpoint, August 2007.

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fundamental issues about the Fed’s role, and what role Congress should play in
assessing those issues. This report reviews the Fed’s actions since August 2007 and
analyzes the policy issues raised by those actions.
Traditional Tools
The Fed, the nation’s central bank, was established in 1913 by the Federal
Reserve Act (38 Stat. 251). Today, its primary duty is the execution of monetary
policy through open market operations to fulfill its mandate to promote stable
economic growth and low and stable price inflation. Besides the conduct of
monetary policy, the Federal Reserve has a number of other duties: it regulates
financial institutions, issues paper currency, clears checks, collects economic data,
and carries out economic research. Prominent in the current debate is one particular
responsibility: to act as a lender of last resort to the financial system when capital
cannot be raised in private markets in order to prevent financial panics. The next two
sections explain the Fed’s traditional tools, open market operations and discount
window lending, and summarizes its recent use of those tools.
Open Market Operations and the Federal Funds Rate
Open market operations are carried out through the purchase and sale of U.S.
Treasury securities in the secondary market in order to alter the reserves of the
banking system.4 By altering bank reserves, the Fed can influence short-term interest
rates, and hence overall credit conditions. The Fed’s target for open market
operations is the federal funds rate, the rate at which banks lend to one another on an
overnight basis. The federal funds rate is market determined, meaning the rate
fluctuates as supply and demand for bank reserves change. The Fed announces a
target for the federal funds rate and pushes the market rate toward the target by
altering the supply of reserves in the market through the purchase and sale of
Treasury securities.5 More reserves increase the liquidity in the banking system and,
in theory, should make banks more willing to lend, spreading greater liquidity
throughout the financial system.
When the Fed wants to stimulate economic activity, it lowers the federal funds
target, which is referred to as expansionary policy. Lower interest rates stimulate
economic activity by stimulating interest-sensitive spending, which includes physical
capital investment (e.g., plant and equipment) by firms, residential investment
(housing construction), and consumer durable spending (e.g, automobiles and
appliances) by households. Lower rates would also be expected to lead to a lower
4 Some of the Fed’s purchase and sale of Treasury securities are made outright, but most are
made through repurchase agreements, which can be thought of as short-term transactions
that are automatically reversed at the end of a predetermined period, typically lasting a few
days. Since the Fed must constantly adjust the amount of bank reserves available in order
to keep the federal funds rate near its target, repurchase agreements give the Fed more
flexibility to make these adjustments.
5 For more information, see CRS Report RL30354, Monetary Policy and the Federal
Reserve: Current Policy and Conditions
, by Marc Labonte and Gail Makinen.

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value of the dollar, all else equal. A lower dollar would stimulate exports and the
output of U.S. import-competing firms. To reduce spending in the economy (called
contractionary policy), the Fed raises interest rates, and the process works in reverse.
Central banks across the world, including Europe, Japan, and the United States
acted quickly to restore liquidity to the financial system following August 9. On a
normal day, the Fed might need to buy or sell a couple billion dollars of Treasury
securities in order to keep the federal funds rate within a few one-hundredths of a
percent of its target. Suddenly on August 9, the federal funds rate approached 6%,
and the Fed was forced to purchase $24 billion of Treasury securities in order to add
enough liquidity to bring the federal funds rate back down to its target of 5.25%. On
August 10, the Fed needed to purchase an additional $38 billion to keep the rate at
its target, and issued a statement that began, “The Federal Reserve is providing
liquidity to facilitate the orderly functioning of financial markets.” The European
Central Bank provided 156 billion euros ($215 billion) of liquidity to markets on
August 9 and 10. Normalcy soon returned to the federal funds market, although other
parts of the financial system remained illiquid. The Fed took similar actions on
March 7, 2008, when it announced that it would be injecting up to $100 billion in
liquidity for at least 28 days through open market operations.
How should the Fed’s actions of August 9-10 and March 7 be characterized?
The Fed’s actions cannot be classified as a policy change since it left the federal
funds target rate unchanged — in the former case for over a month.6 Nor can it be
considered unusual that the Fed bought Treasury securities to keep the federal funds
rate at its target — the Fed does this on a daily basis. What was unusual about the
incidents was the magnitude of liquidity the Fed needed to add to keep the rate near
its target.
On September 18, 2007, the Fed reduced the federal funds target rate by 0.5
percentage points to 4.75%, stating that the change was “intended to forestall some
of the adverse effects on the broader economy that might otherwise arise from the
disruptions in financial markets...” Since then, the Fed has aggressively lowered
interest rates several times. The Fed decides whether to change its target for the
federal funds rate at meetings scheduled every six weeks. In normal conditions, the
Fed would typically leave the target unchanged or change it by 0.25%. From
September to March, the Fed lowered the target at each regularly scheduled meeting,
by an increment larger than 0.25% at most of these meetings. It also lowered the
target by 0.75% at an unscheduled meeting on January 21, 2008.
The Discount Window
The Fed can also provide liquidity to member banks (depository institutions that
are members of the Federal Reserve system) directly through discount window
lending.7 Discount window lending dates back to the early days of the Fed, and was
6 Although no change in the targeted rate was announced, the Fed allowed the actual federal
funds rate to fall below 5% on most days over the next month.
7 For more background, see James Clouse, “Recent Developments in Discount Window
(continued...)

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originally the Fed’s main policy tool. (The Fed’s main policy tool shifted from the
discount window to open market operations several decades ago.) Loans made at the
discount window are backed by collateral in excess of the loan value. A wide array
of assets can be used as collateral, but they must generally have a high credit rating.
Most discount window lending is done on an overnight basis. Unlike the federal
funds rate, the Fed sets the discount rate directly through fiat.
During normal market conditions, the Fed has discouraged banks from
borrowing at the discount window on a routine basis, believing that banks should be
able to meet their reserve needs through the market. In 2003, the Fed made that
policy explicit in its pricing by changing the discount rate from 0.5 percentage points
below to 1 percentage point above the federal funds rate. A majority of member
banks do not access the discount window in any given year. Since the beginning of
the financial turmoil, the Fed has reduced the spread between the federal funds rate
and the discount rate, although it has kept the spread positive.
On August 17, 2007, the Fed took further actions to restore calm to financial
markets when it reduced the discount rate from 6.25% to 5.75%. Since then, the
discount rate has been lowered several times, typically at the same time as the federal
funds rate. Discount window lending (in the primary credit category) increased from
a weekly average of $45 million in July 2007 to $701 million in August to $1,345
million in September. Although expanded discount window lending has been an
important source of liquidity during the financial turmoil, it is dwarfed by open
market operations. Discount window lending involves millions of dollars whereas
open market operations involve billions of dollars on a daily basis.
New Tools
The Fed’s traditional tools are aimed at the commercial banking system, but
current financial turmoil has occurred outside of the banking system as well. The
inability of traditional tools to calm financial markets since August has led the Fed
to develop several new tools to fill perceived gaps between open market operations
and the discount window.
Term Auction Facility
A stigma is thought to be attached to discount window lending. In good times,
discount window lending has traditionally been discouraged on the grounds that
banks should meet their reserve requirements through the marketplace (through the
federal funds market) rather than the Fed. Borrowing from the Fed was therefore
seen as a sign of weakness, as it implied that market participants were unwilling to
lend to the bank because of fears of insolvency. In the current turmoil, this
perception of weakness could be particularly damaging since a bank could be
undermined by a run based on unfounded, but self-fulfilling fears. Ironically, this
means that although the Fed encourages discount window borrowing so that banks
7 (...continued)
Policy,” Federal Reserve Bulletin, November 1994, p. 965.

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can avoid liquidity problems, banks are hesitant to turn to the Fed because of fears
that doing so would spark a crisis of confidence. As a result, the Fed found the
discount window a relatively ineffective way to deal with liquidity problems in the
current turmoil. It created the supplementary Term Auction Facility (TAF) in
response.8
Discount window lending is initiated at the behest of the requesting institution
— the Fed has no control over how many requests for loans it receives. The TAF
allows the Fed to determine the amount of reserves it wishes to lend out, based on
market conditions. The auction process determines the rate at which those funds will
be lent, with all bidders receiving the lowest winning bid rate. The winning bid may
not be lower than the prevailing federal funds rate. Determining the rate by bid
provides the Fed with additional information on how much demand for reserves
exists.
Any depository institution eligible for discount window lending can participate
in the TAF. Auctions through the TAF have been held twice a month beginning in
December 2007. The amounts auctioned — initially $20 billion but later increased
— have greatly exceeded discount window lending, which averages in the hundreds
of millions of dollars a month, whereas the TAF averages in the tens of billions. Like
discount window lending, TAF loans must be fully collateralized with the same
qualifying collateral. As with discount window lending, the Fed faces the risk that
the value of collateral would fall below the loan amount in the event that the loan was
not repaid. For that reason, the amount lent diminishes as the quality of the collateral
diminishes.
Loans mature in 28 days — far longer than loans in the federal funds market or
the typical discount window loan. Another motivation for the TAF may have been
an attempt to reduce the unusually large divergence that had emerged between the
federal funds rate and interbank lending rates for longer maturities. This divergence,
which can be seen as a sign of how much liquidity had deteriorated in spite of the
Fed’s previous efforts, became much smaller after December.
The TAF program was announced as a temporary program that could be made
permanent after assessment. Given that the discount rate is set higher than the federal
funds rate to discourage its use in normal market conditions, it is unclear what role
a permanent TAF would fill, unless the funds auctioned were minimal in normal
market conditions. A permanent TAF would seem to run counter to the philosophy
governing the discount window that financial institutions, if possible, should rely on
the private sector to meet their short-term reserve needs during normal market
conditions.
8 Charles Carlstrom and Sarah Wakefield, “The Funds Rate, Liquidity, and the Term
Auction Facility,” Federal Reserve Bank of Cleveland, Economic Trends, December 14,
2007.

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Term Securities Lending Facility
For many years, the Fed has allowed primary dealers (see box for definition) to
swap Treasuries of different maturities or attributes with the Fed on an overnight
basis through a program called the System Open Market Account Securities Lending
Program to help meet the dealers’ liquidity needs. (While all Treasury securities are
backed by the full faith and credit of the federal government, some securities are
more liquid than others, mainly because of differences in availability.) Securities
lending has no effect on general interest rates or the money supply since it does not
involve cash, but can affect the liquidity premium of the securities traded. Since the
loans were overnight and collateralized with other Treasury securities, there was very
little risk for the Fed.
What is a Primary Dealer? Primary dealers are about 20 large financial
institutions who are the counterparties with which the Fed undertakes open market
operations (buying and selling of Treasury securities). In order to be a primary
dealer, an institution must, among other things, meet relevant Basel or SEC capital
requirements and maintain a good trading relationship with the Fed.
On March 11, 2008, the Fed set up a more expansive securities lending program
for the primary dealers called the Term Securities Lending Facility. Under this
program, up to $200 billion of Treasury securities could be lent for 28 days instead
of overnight, and could be collateralized with U.S. Treasuries, government “agency”
debt (including debt issued by Fannie Mae and Freddie Mac), mortgage-backed
securities (MBS) issued by government agencies or private labels with an AAA/Aaa
rating, agency commercial mortgage backed securities, and agency collateralized
mortgage obligations. Given the recent drop in MBS prices, this made the new
lending program considerably more risky than the old one. But the scope for losses
are limited by the fact that the loans are fully collateralized with a “haircut” (i.e., less
money is loaned than the value of the collateral), and if the collateral loses value
before the loan is due, the Fed can call for substitute collateral. The first auction on
March 27 involved $75 billion of securities.
By allowing the primary dealers to temporarily swap illiquid assets such as MBS
for highly liquid Treasuries, “[t]he TSLF is intended to promote liquidity in the
financing markets for Treasury and other collateral and thus to foster the functioning
of financial markets more generally,” according to the Fed.9 Given the timing of the
announcement — less than a week before the failure of one of its primary dealers,
Bear Stearns — critics have alleged that the program was created, in effect, in an
attempt to rescue Bear Stearns from its liquidity problems. But it should be noted
that the new program did not involve Bear Stearns’ most illiquid and devalued assets
that investors and counterparties (individuals or firms who had entered into
transactions with Bear Stearns) were most concerned about. As will be discussed
below, the Fed would take much larger steps to aid Bear Stearns later the same week.
9 Board of Governors of the Federal Reserve System, press release, March 11, 2008.

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Primary Dealer Credit Facility
On March 16, the Fed announced a direct lending program for primary dealers
very similar to the discount window program for depository institutions — a day too
late to help Bear Stearns. Loans will be made on an overnight basis at the discount
rate, limiting their riskiness. Acceptable collateral includes Treasuries, government
agency debt, and investment grade corporate, mortgage-backed, asset-backed, and
municipal securities. Many of these classes of assets can and have fluctuated
significantly in value. Fees will be charged to frequent users.
The program was announced as lasting six months, or longer if events warrant.
The program is authorized under paragraph 3 of Section 13 of the Federal Reserve
Act, which allows lending to non-banks under “exigent and unusual circumstances,”
which suggests it could not be made permanent under existing authorization.
Although the program shares some characteristics with the discount window and
the Term Securities Lending Facility, the fact that the program was authorized under
paragraph 3 of Section 13 suggests that there is a fundamental difference between
this program and the Fed’s normal operations. The Fed is referred to as the nation’s
central bank because it is at the center of the banking system — providing reserves
and credit, and acting as a regulator, clearinghouse, and lender of last resort to the
banking system. The privileges for banks that come from belonging to the Federal
Reserve system — access to credit — come with the costs of regulation to ensure
that banks with access to Fed credit do not take excessive risks. Although the
primary dealers are subject to capital requirements, they are not necessarily part of
the banking system, and do not fall under the same regulatory structure as the banks.
The Fed’s Role in the JP Morgan Chase Acquisition
of Bear Stearns
Bear Stearns came under severe liquidity pressures in early March, in what
many observers have coined a non-bank run.10 On Friday, March 14, JP Morgan
Chase announced that, in conjunction with the Federal Reserve, it had agreed to
provide secured funding to Bear Stearns, as necessary, for an initial period of up to
28 days. Through its discount window, the Fed agreed to provide $13 billion of
back-to-back financing to Bear Stearns via JP Morgan Chase. It was a non-recourse
loan, meaning that the Fed had no general claim against JP Morgan Chase in the
event that the loan was not repaid and the outstanding balance exceeded the value of
the collateral. Bear Stearns could not access the discount window directly because,
at that point, only member banks could borrow directly from the Fed. This loan was
superseded by the events of March 16, and the loan was repaid in full on March 17.
On Sunday, March 16, after negotiations between the two companies, the Fed
and the Treasury, JP Morgan Chase agreed to acquire Bear Stearns. As part of the
10 For more information, see CRS Report RL34420, Bear Stearns: Crisis and ‘Rescue’ for
a Major Provider of Mortgage-Related Products
, by Gary Shorter.

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agreement, the Fed will purchase up to $30 billion of Bear Stearns’ assets through a
Limited Liability Corporation (LLC) based in Delaware that it has created and
controls. Upon its creation, two loans will be made to the LLC: the Fed will lend the
LLC up to $29 billion, and JP Morgan Chase will make a subordinate loan to the
LLC worth $1 billion.11 The Fed’s loan will be made at an interest rate set equal to
the discount rate (2.5% when the terms were announced, but fluctuating over time)
for a term of 10 years, renewable by the Fed.12 JP Morgan Chase’s loan will have an
interest rate 4.5 percentage points above the discount rate.
Using the proceeds from that loan, the LLC will purchase assets from Bear
Stearns worth $30 billion at marked to market prices by Bear Stearns on March 14.
The Fed reported that
The portfolio supporting the credit extensions consists largely of mortgage-
related assets. In particular, it includes cash assets as well as related hedges. The
cash assets consist of investment grade securities (i.e. securities rated BBB- or
higher by at least one of the three principal credit rating agencies and no lower
than that by the others) and residential or commercial mortgage loans classified
as “performing”. All of the assets are current as to principal and interest (as of
March 14, 2008). All securities are domiciled and issued in the U.S. and
denominated in U.S. dollars. The portfolio consists of collateralized mortgage
obligations (CMOs), the majority of which are obligations of
government-sponsored entities (GSEs), such as the Federal Home Loan
Mortgage Corporation (“Freddie Mac”), as well as asset-backed securities,
adjustable-rate mortgages, commercial mortgage-backed securities, non-GSE
CMOs, collateralized bond obligations, and various other loan obligations.13
The LLC will own these assets, and will liquidate them in order to pay back the
principal and interest owed to the Fed and JP Morgan Chase. The LLC's assets
(purchased from Bear Stearns) are the collateral backing the loans from the Fed and
JP Morgan Chase. A private company, BlackRock Financial Management, has been
hired to manage the portfolio. Neither Bear Stearns nor JP Morgan Chase owe the
Fed any principal or interest, nor are they liable if the LLC is unable to pay back the
money the Fed lent it. The New York Fed explained that the LLC was created to
"ease administration of the portfolio and will remove constraints on the money
manager that might arise from retaining the assets on the books of Bear Stearns."14
JP Morgan Chase and Bear Stearns will not receive the $29 billion from the LLC
11 A subordinate loan is one where the principal and interest are not repaid until after the
primary loan is repaid.
12 Federal Reserve Bank of New York, “Summary of Terms and Conditions Regarding the
JP Morgan Chase Facility,” press release, March 24, 2008. Many of the details of the loan,
including the size ($29 billion), were not announced on March 16.
13 Timothy Geithner, “Testimony Before the Senate Committee for Banking, Housing and
Urban Affairs,” April 3, 2008, Annex II.
14 Federal Reserve Bank of New York, “Summary of Terms and Conditions Regarding the
JP Morgan Chase Facility,” press release, March 24, 2008.

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until the merger is complete.15 In the meantime, JP Morgan Chase and the Fed have
delegated control of the assets to the LLC, including the right to liquidate them
before the merger.
It was announced that the Fed is planning to begin liquidating the assets after
two years. The assets will be sold off gradually, “to minimize disruption to financial
markets and maximize recovery value.”16 As the assets are liquidated, interest will
continue to accrue on the remaining amount of the loan outstanding. Thus, in order
for the principal and interest to be paid off, the assets will need to appreciate enough
or generate enough income so that the rate of return on the assets exceeds the
weighted interest rate on the loans (plus the operating costs of the LLC). Table 1
shows how the funds raised through the liquidation will be used. Any difference
between the proceeds and the amount of the loans is profit or loss for the Fed, not JP
Morgan Chase. Because JP Morgan Chase’s $1 billion loan was subordinate to the
Fed’s $29 billion loan, if there are losses on the $30 billion assets, the first $1 billion
of losses will be borne, in effect, by JP Morgan Chase, however. The interest on the
loan will be repaid out of the asset sales, not by JP Morgan Chase.
Table 1. Use of Funds Raised by Liquidation of Bear Stearns
Assets
Payments from the liquidation will be made in the following order:
(1) operating expenses of the limited liability corporation
(2) $29 billion principal owed to the Federal Reserve
(3) interest due to the Federal Reserve on the $29 billion loan
(4) $1 billion principal owed to JP Morgan Chase
(5) interest due to JP Morgan Chase on $1 billion subordinated note
(6) non-operating expenses of the limited liability corporation
(7) remaining funds accrue to Federal Reserve
Source: Federal Reserve Bank of New York.
Note: Each category must be fully paid before proceeding to the next category.
The Fed’s statutory authority for its role in both Bear Stearns transactions comes
from paragraph 3 of Section 13 of the Federal Reserve Act:
In unusual and exigent circumstances, the Board of Governors of the Federal
Reserve System, by the affirmative vote of not less than five members, may
authorize any Federal reserve bank...to discount for any individual, partnership,
15 Timothy Geithner, “Testimony Before the Senate Committee for Banking, Housing and
Urban Affairs,” April 3, 2008, p. 17.
16 Federal Reserve Bank of New York, “Statement on Financing Arrangement of JP Morgan
Chase’s Acquisition of Bear Stearns,” press release, March 24, 2008.

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or corporation, notes, drafts, and bills of exchange.... Provided, that before
discounting any such note, draft, or bill exchange...the Federal reserve bank shall
obtain evidence that such individual, partnership, or corporation is unable to
secure adequate credit accommodations from other banking institutions...
According to the New York Federal Reserve, this authority had not been used in
about 70 years prior to the Bear Stearns incident.17
There has not been an official explanation as to why JP Morgan Chase was
unwilling to include the assets purchased by the LLC in their merger deal. Since JP
Morgan Chase will not receive the $29 billion until the acquisition of Bear Stearns
is official, it does not appear that the money was needed to meet its short-term
liquidity needs. One possibility is that, given the significant downward trend in MBS
recently, including the assets in the deal could have made it unacceptably risky for
JP Morgan Chase. JP Morgan Chase may have believed that the assets were worth
(at present or a future date) significantly less than the current market value of $30
billion. Had the transaction been crafted as a typical discount window loan directly
to JP Morgan Chase, JP Morgan Chase would have been required to pay back the
principal and interest, and it (rather than the Fed) would have borne the full risk of
any depreciation in value of Bear Stearns’ assets.
In his testimony, New York Fed President Timothy Geithner stated that the Fed
did not have authority to acquire an equity interest in Bear Stearns or JP Morgan
Chase.18 Yet the LLC controlled by the Fed acquired assets from Bear Stearns, and
the profits or losses from that acquisition will ultimately accrue to the Fed. It is
unclear why the Fed decided to create and lend to a LLC to complete the transaction,
rather than engaging in the transaction directly. Although the Fed did not buy Bear
Stearns' assets directly, there are certainly important policy questions raised by the
Fed's creation and financing of an LLC in order to buy Bear Stearns' assets.
Typically, the Fed lends money to institutions and receives collateral in return. When
the loan is repaid, the collateral is returned to the institution. In this case, the Fed
made a loan, but to a LLC they created and controlled, not to a financial institution.
From the perspective of JP Morgan Chase or Bear Stearns, the transaction was a sale
(to the LLC), not a loan, regardless of whether the Fed or the LLC was the principal.
Policy Issues
Cost to the Treasury
Unlike all other institutions, currency (Federal Reserve notes) is the Fed’s
primary liability. Along with its holdings of Treasury securities, its assets are the
loans it makes (through the discount window, the new programs detailed above, and
for the Bear Stearns takeover). Making loans increases its assets and liabilities, and
does not inherently impose any cost to the Treasury. Indeed, if the loans are repaid,
17 Federal Reserve Bank of New York, “The Discount Window,” Fedpoint, August 2007.
18 Timothy Geithner, “Testimony Before the Senate Committee for Banking, Housing and
Urban Affairs,” April 3, 2008, p. 13.

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they would increase the profits of the Fed, which in turn would increase the Fed’s
remittances to the Treasury.19 Even if the loans are not repaid, they are fully
collateralized (in some cases, overcollateralized), so the Fed would not suffer losses
unless the collateral had lost value. In addition, some of the loans discussed above
are made with recourse, which means that the firms are liable if the collateral loses
value.
The Fed had net income of $34.2 billion and remitted $29.1 billion to the
Treasury in 2006. Most of the Fed’s net income derives from the interest on its
Treasury securities holdings, not its loans. If the loans were not repaid in full and the
collateral lost value, it would reduce the net income of the Fed, and therefore its
remittances to the Treasury. If loan losses caused an overall net loss, the Fed’s
capital (the excess of its assets compared to its liabilities) would be reduced. The Fed
had capital of $30.6 billion at end of 2006, half of which was paid-in capital of
member banks and the other half which was surplus. The Fed has not had an annual
net operating loss since 1915.
Thus, any potential losses on loans to the Fed would not involve taxpayer
dollars unless the losses exceeded the sum of its other earnings and its capital.
However, smaller losses could result in a smaller remittance of earnings to the
Treasury than would have occurred had the Fed not made the loans.
Lender of Last Resort, Systemic Risk, and Moral Hazard
The lender of last resort function can be seen from the perspective of an
individual institution or the financial system as a whole.20 From the perspective of
the individual institution, discount window lending is meant to provide funds to
institutions that are illiquid (cannot meet current obligations out of current cash flow)
but still solvent (assets exceed liabilities) when they cannot access funds from the
private market. Discount window lending was unable to end bank runs, however —
bank runs did not cease until the creation of federal deposit insurance. The
experience of the Great Depression suggested that bank runs placed intolerably high
costs on the financial system as a whole, as they led to widespread bank failures.21
Discount window lending is not meant to help insolvent institutions, with one
exception explained below. Access to discount window lending and deposit
insurance creates moral hazard for financial institutions — they can take on more
risk than the market would otherwise permit because of the government safety net.
In order to limit moral hazard, institutions with depository insurance and access to
19 Assuming that the interest rate on the loans exceeded the rate of return on the Treasuries
that the Fed would have purchased if the loans had not occurred.
20 For more information, see CRS Report RS21986, Federal Reserve: Lender of Last Resort
Functions
, by Marc Labonte.
21 In this context, it is interesting to note that the Bear Stearns failure has been described as
a non-bank run, meaning it was undone because it was shunned by its counterparties and
investors, analogous to a bank being shunned by its depositors. The defining characteristic
of a run is that the fear of failure becomes self-fulfilling since it deprives an institution of
the resources it needs to avoid failure.

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the discount window are subject to a safety and soundness regulatory regime that
includes capital requirements, reserve requirements, bank examinations, and so on.
The exception to the rule that insolvent institutions cannot access the discount
window is when the institution is deemed “too big to fail.” Institutions that are too
big to fail are ones that are deemed to be big enough that their failure could create
systemic risk, the risk that the financial system as a whole would cease to function
smoothly.22 A systemic risk episode could impose heavy costs on the overall
economy, as the bank panics of the Great Depression demonstrated. Although too
big to fail institutions are not offered explicit guarantees, it can be argued that they
have implicit guarantees since the government would not be willing to allow a
systemic risk episode. This accentuates the moral hazard problem described above.
There is no official governmental reckoning of which financial institutions are too
big to fail, presumably since maintaining uncertainty over which institutions are too
big to fail could help reduce the moral hazard problem. But the lack of official
designation arguably creates a vacuum in terms of policy preparedness. (Making the
problem more complex, as one report described the situation, “Officials grimly
concluded that while Bear Stearns isn’t too big to fail, it was too interconnected to
be allowed to fail in just one day.” It is unclear how to judge which institutions are
too interconnected to fail.)23
As the Bear Stearns episode illustrates, some of the modern-day financial
institutions that are too big to fail are not depository institutions that fall under the
strict regulatory umbrella that accompanies membership in the Federal Reserve
system. It is possible that part of the reason Bear Stearns failed is because it took on
excessive risks in the belief that it was too big to fail. Although that theory cannot
be proven at this time, it is clearer that the precedent of the Fed’s role in the Bear
Stearns acquisition may enhance the perception of other institutions and investors
that any financial firm, regardless of whether it is a depository institution, will be
bailed out in the future if it is too big to fail, or merely too interconnected to fail. If
so, it could be argued that the Bear Stearns episode may have increased moral hazard
going forward.
Some critics have argued that even the Fed’s rate cuts last fall, before there were
signs of an economy-wide slowdown, fostered moral hazard because they signaled
to investors that any sudden drop in asset prices will be offset by monetary
expansion. While generalized intervention may improve overall financial market
conditions, it does not target specific depressed assets. Therefore, any moral hazard
created by general monetary policy is indirect at best — after all, certain asset prices
have continued to decline despite the Fed’s recent policy easing. While the Fed’s
recent actions may cumulatively give the appearance of “bailing out” the financial
system, its ultimate goal is economic stability, which it believes that financial turmoil
would undermine. Given the lags between monetary changes and their effect on the
22 For more information, see CRS Report RL34412, Averting Financial Crisis, by Mark
Jickling.
23 Greg Ip, “Central Bank Offers Loans to Brokers, Cuts Key Rate,” Wall Street Journal,
March 17, 2008, p. A1.

CRS-13
economy, the Fed must respond to financial turmoil before it feeds through to the
overall economy if it wants to minimize the turmoil’s economic effects.
Going forward, policymakers must determine whether new regulation is needed
to limit moral hazard since there may be no credible way to maintain a policy that
prohibits the rescue of future institutions that are too big to fail even if such a policy
was desired. The alternative is the status quo, which could be described as allowing
systemic risk episodes to break out, and counting on the Fed to step in after the fact
and flood the market with liquidity to restore order. The current situation raises three
broad points about systemic risk. First, risk is at the foundation of all financial
intermediation. Policymakers may wish to curb excessive risk taking when it leads
to systemic risk, but too little financial risk would also be counterproductive for the
economy. (Indeed, some would argue that part of the underlying problem for the
financial system as a whole at present is that investors are currently too risk averse.)
Second, many analysts have argued that part of the reason that so much financial
intermediation has left the commercial banking system is to avoid the costs of
regulation. This point applies to future regulatory changes as well. An attempt to
increase regulation on investment banks could lead more business to move to hedge
funds, for example. Third, financial markets have become significantly more
complex and fast-moving in recent years. Many of the financial instruments with
which Bear Stearns was involved did not exist until recently. For regulation to be
effective in this environment, it faces the challenge of trying to keep up with
innovation. If used prudently, many of these innovations can reduce risk for
individual investors. Yet the Bear Stearns example implies that innovation may also
lead to more interconnectivity, which increases systemic risk.
Liquidity Trap?
Some economists have argued that the Fed’s recent string of newly created
programs points to an increasing desperation on its part to “right the ship.” Although
monetary policy has successfully contributed to an unusual degree of economic
stability since at least the mid-1980s, they argue that it has been rendered ineffective
by the current scenario. They argue that lower interest rates will not boost spending
because the economy is stuck in a credit crunch in which financial institutions are
unwilling to lend to creditworthy borrowers because of balance sheet concerns.
Borrower demand may increase in response to lower rates, but as long as institutions
are trying to rebuild their balance sheets, they will remain unwilling to extend credit.
This problem is sometimes referred to as a “liquidity trap.” Liquidity traps are rare
in modern times, but the decade of economic stagnation suffered by Japan in the
1990s after the bursting of its financial bubble is often cited as the prime example.
Interest rates were lowered to almost zero in Japan, and the economy still did not
recover quickly.24
24 While the term liquidity trap was often applied to Japan, it is theoretically defined as a
situation where household demand for money becomes infinite, so changes in the money
supply do not affect interest rates. Under this strict definition, it is not clear that Japan, or
any other economy, has experienced a liquidity trap.

CRS-14
There are some problems with this line of reasoning at present. First, liquidity
traps are seen as an extreme form of recession, but while the U.S. economy had
slowed (as of early 2008), it had not yet officially entered a recession and had not
experienced even one quarter of economic contraction. Second, liquidity traps are
most likely to occur when overall prices of goods and services are falling (called
deflation). The Fed cannot reduce the federal funds rate below zero. When prices
are falling, real interest rates are higher than nominal interest rates, so it is more
likely that a very low nominal interest rate would still be too high in real terms to
stimulate economic activity. But inflation has been rising, not falling, recently.25
Inflation would not be expected to rise persistently if the economy were in a liquidity
trap. Third, there is a more benign, well-documented explanation for why the Fed’s
expansionary policy has not yet stimulated economic activity — monetary policy
always suffers lags between a reduction in interest rates and corresponding increase
in economic activity. While a liquidity trap cannot be ruled out, it is premature to
conclude the economy is stuck in one at this point in time.
Stagflation?
Some observers believe the U.S. economy is in a liquidity trap, whereas other
critics have argued that the Fed has created the opposite problem — rising inflation
due to excessive liquidity. They argue that the economy has entered a period of
stagflation, where falling or negative economic growth is accompanied by high or
rising inflation.
Typically, one would expect an economic slowdown to be accompanied by a
decline in the inflation rate. Excess capacity in the capital stock and rising
unemployment would force firms and workers to lower their prices and wage
demands, respectively. But critics believe the economy is in a situation where a
modest but persistent increase in inflation in recent years has led individuals to come
to expect higher inflation, and factor that expectation in to their price and wage
demands. Couple those higher inflation expectations with rising commodity prices
and the recent unusual large liquidity injections by the Fed, and critics argue that
inflation will rise even if the economy slows. They point to the experience of the
1970s, when inflationary expectations became so ingrained that inflation continued
to rise despite a fairly deep recession, as a potential parallel to the current situation.
Data suggest that the fear of stagflation is premature — both unemployment and
inflation remain relatively low at present. It is true that in the long run inflation is a
monetary phenomenon, and if the Fed’s recent actions were made permanent, they
would not be consistent with stable inflation. But in the near term, if unemployment
and excess capacity rose, that would be expected to take much of the pressure off of
the inflation rate. Ironically, if the Fed’s actions succeed in reviving the economy,
then the probability that its actions would boost inflation would increase. The key
to maintaining a stable inflation rate is finding the proper balance between the
deflationary pressures of the slowdown and the inflationary pressures of
expansionary monetary policy and rising commodity prices. The large amounts of
25 Asset prices have been falling lately, but they are not included in standard measures of
inflation, which measures the prices of goods and services.

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liquidity that the Fed has added to the system must be removed soon enough that
inflation does not rise, but not so soon that a nascent financial recovery is stubbed
out. Given the uncertainty facing policymakers at present, finding the proper balance
is extremely difficult.
Concluding Thoughts
Although turmoil plagues financial markets periodically, the current episode is
notable for its breadth and persistence. It is difficult to make the case that the Fed
has not responded to the current turmoil with alacrity and creativity. But its response
has raised statutory issues that Congress may wish to consider in its oversight
capacity. Namely, the Fed’s role in the Bear Stearns acquisition and the creation of
the Primary Dealer Credit Facility (a sort of discount window for a group of non-
member banks) involved emergency authorities that had not been used in more than
70 years. This authority was needed because both actions involved financial
institutions that were not member banks (i.e., depository institutions). The authority
allows lending to non-member banks, but the loan in the Bear Stearns agreement is
to a LLC that the Fed created and controls, and is being used to purchase Bear
Stearns’ assets. These actions raise an important issue — if financial institutions can
receive some of the benefits of Fed protection, perhaps because they are “too big to
fail,” should they also be subject to the costs that member banks bear in terms of
safety and soundness regulations, imposed to limit the moral hazard that inevitably
results from Fed and FDIC (Federal Deposit Insurance Corporation) protections? If
so, should the too big to fail label be made explicit so that regulators can better
manage systemic risks?